US Banks and Traders Wary of Two-Step Stress Test

Investors in U.S. bank stocks may be in for a volatile ride over the next two weeks as the Federal Reserve releases results of its annual stress tests of bank capital in two steps.

Late on Thursday, the agency is expected to reveal how much capital 18 large banks would maintain under a hypothetical severe economic downturn. A week later, the Fed plans to disclose how the banks would have fared if they had first spent some of their capital buying back shares or paying higher dividends.

Among the banks that will be closely watched are Bank of America and Citigroup, which have stumbled in past tests and have had quarterly dividends stuck at a penny per share since the financial crisis.

If banks pass Fed muster, they will be allowed to go ahead with plans to increase payouts and repurchase more shares. Last year, the Fed disclosed all of the information on the same day.

During this year's one-week gap, bankers are worried that their stocks could face volatile swings as analysts and investors try to guess how much capital banks will be able to return to shareholders over the next year. Stocks could also fluctuate if banks exceed or miss expectations for how they will score in the first phase of the test, the bankers said.

"I'd much rather get all the information in one fell swoop," said Frank Barkocy, director of research at Mendon Capital Advisors, which invests in bank stocks. "It does create some air of uncertainty, and uncertainty usually results in volatility."

Barkocy said it's also possible that information could leak out during the interim week. The Fed will provide banks with preliminary information about their capital plans this week, but it's considered confidential supervisory information.

It would be "much cleaner" if the Fed were to release both parts on one date, bank analyst Vivek Juneja of JPMorgan said in a research report.

The two-step process was created because this year banks will get a one-time chance to lower their requests for dividend increases and buybacks once they know how they fared in the stress test. The Fed declined to comment on the possibility of volatile stock prices during the one-week period.

Bank stocks have enjoyed a strong run, with the KBW Bank Index climbing more than 30 percent last year and another 6 percent this year. Analysts said they aren't expecting the test results to provide a major boost to shares, but said investors could be disappointed if banks return less capital than expected or have their requests rejected by the Fed.

The Fed started special stress tests of banks in 2009 in the financial crisis. Some banks had to pad their capital levels, but the tests were seen as a key step in rebuilding confidence in the financial system.

This year's tests are the regulator's third review of large banks since then, and each time the Fed has handled how it discloses the results differently.

After keeping details of the 2011 tests confidential, the Fed decided to publicly reveal its March 2012 results. The announcement, however, came out two days earlier than expected and included an early release of dividend and share buyback information for JPMorgan Chase, which surprised the market.

Last year Citigroup failed the test when it asked to return more capital through share buybacks or dividends than the Fed thought was safe. Citigroup initially said it would apply again to spend capital in 2012, but after a few months decided to wait until this year's test to make another bid.

Along with Citigroup, three other banks out of the 19 tested also failed last year - SunTrust Banks, auto lender Ally Financial Inc and insurer MetLife. MetLife will not be part of the test this year because it has sold off banking operations.

Even with the Fed this year offering a quick do-over, bankers are likely to be cautious in their applications, analysts say. There is too great a risk of a public failure that would reflect poorly on a bank's risk management and its relationships with regulators, Richard Ramsden, bank analyst at Goldman Sachs Group, wrote in a report this week.

Citigroup CEO Mike Corbat recently told investors that the company prepared this year's capital plan with "mission one, really to put a submission in where we could get approval." The second goal, he said, was to continue building up capital to meet coming new requirements from regulators.

Possibly working against Citigroup is the fact that this year the stress scenarios include bigger swings in economies in developing countries in Asia, where the company does more business than other banks, according to Ramsden.

Analysts expect that the first results due on Thursday will show that the vast majority of banks would stay above a minimum Tier 1 common capital ratio of 5 percent in the severe economic scenario. Far less certain is how much capital each banks will be able to return to shareholders through dividends and stock buy backs.

Analysts, on average, expect Citigroup will be allowed to raise its quarterly dividend from a nominal 1 cent per share to about 10 cents, according to a survey by Thomson Reuters. But some analysts caution that Citigroup may not increase its dividend at all.

Some analysts say bank executives have been downplaying expectations for payouts because banks still need to build enough capital to meet new international standards. Banks also need to show they have sufficient risk management practices to win approval for payouts.

Analysts say Bank of America could receive approval for a small boost this year. Bank of America CEO Brian Moynihan has cautioned the bank needs to show it can produce consistent earnings as it continues to reach costly mortgage-related settlements.

JPMorgan CEO Jamie Dimon has said his bank has asked for permission to buy back less stock than the $3 billion per quarter that was approved in 2012 because it wants to build up capital ahead of higher requirements. He has also said that the bank wants each year to increase its quarterly dividend, which is now 30 cents.

Executives at Wells Fargo, the fourth-biggest U.S. bank by assets, have said the bank has asked the Fed for permission to return more capital to shareholders.